The Paradox of Prime

Prime brokerage has had an interesting relationship with the FX market – after the initial burst of excitement when it first launched in the late 1990s, the middle years of the first decade of this century saw a growing consensus that it was a good idea that had, had its day.

Generally speaking, PB customers were restricted to dealing on a bilateral basis with the major banks, so while there was undoubtedly some benefit involved, the value proposition wasn’t one that lent itself to continued growth.

This all changed with the advent of EBS Prime, initially for regional banks but then, the real catalyst, for hedge funds. By providing something that had long been desired by hedge funds especially – direct access to what was then still the interbank market – a world of opportunity emerged for prime services providers. Out of this evolution came a new generation of high frequency traders who largely morphed into non-bank market makers, and helped drive what seems an irrevocable changing of the market landscape.

This means that prime brokerage played a critical role in one of the biggest changes in the foreign exchange market’s history, however the story was not yet over. For while FX had little or nothing to do with the symptoms of the global financial crisis (GFC), it felt the full force of tightened credit access and increased regulatory oversight. It is in the years since the GFC that the paradox of prime has emerged, for at the same time as banks in particular were seeking to cut back on their client numbers and credit lines, demand for prime brokerage was soaring – driven mainly by non-bank firms seeking to fill what was perceived to be a growing gap in the market making ranks.

To meet this demand, as we study in this special report, a new generation of prime services providers have emerged in FX – and this ‘new generation’ is itself facing a challenge from the next. Wherever the challenges come from and irrespective of how successful they are, it is clear that there are many and varied opportunities in FX prime brokerage at this time.

In a presentation at a recent investor day, Citi’s CEO Michael Corbat indicated that the bank, which is still easily the biggest FX prime broker, had reduced the number of institutional clients in the franchise from over 32,000 to around 14,000 – a 57% decline. While not all of these clients would have been prime brokerage customers, the trend is clear – Citi, as is the case with several other major bank prime brokers, has been cutting customer numbers.

That the motivation for these cuts appears to be cost efficiency rather than risk reduction only serves to reinforce the idea that there has been a transition in prime services – one that has impacted thousands of clients, the majority of whom have had to find a new provider. The demand for prime services is still there, however, for a brief glimpse at the data released by the foreign exchange committees of London and New York reinforces the importance of PB to the FX market.

In the US in April 2017, 72.5%, or $272.1 billion was transacted in spot FX using a prime broker. A data series is not available for the US market, however, this is significantly higher than the 65.9% of volume that was prime brokered in the US in April 2016. It is not only in spot that the impact of PB is being felt in the US though, for $71.3 billion per day, or 37.7%, of outright forward (including NDFs) contracts are PB-ed, as are $35.7 billion of FX swaps (12.4%) and $12.3 billion per day of options (32.7%). The increasing demand for prime services in FX is even clearer in the UK, where data is available going back to 2010 – the time the major PBs started looking to rationalise their customer bases.

From 2010 to 2017, across all products, FX volume via a prime broker has more than doubled to $580.9 billion per day and ticket numbers have more than quadrupled to 606,744 per day. While the volume via PB is slightly below that of April 2013 (a month where a spike in USD/JPY activity produced higher FX volumes across the board), ticket numbers being processed are at an all time high – and likely to go even higher. It is a similar picture when looking at individual products. In spot FX in the UK, $341.5 billion per day is executed using a prime broker, this is 45.7% of all spot volume in the world’s biggest FX market and represents an 84% increase in spot volume via a PB since 2010.

The growth in NDFs, outright forwards and options – favoured products of a lot of speculative traders – is even more striking. NDF volume via a prime broker has multiplied more than tenfold to $22.5 billion and again as a percentage of volume it has almost quadrupled. Outright forwards volume via prime brokers has almost quadrupled and the sector’s share of volume has tripled (to $64.7 billion and 25.1%, respectively). FX options volume via a PB has more than trebled to $57.7 billion per day and its share of activity has more than doubled to 39.1%.

Even FX swaps, a very difficult product to prime broke in the modern regulatory era, has seen both its share of volume increase – from 7.2% to 8% – and its notional volume, from $54.2 billon to $93.7 billion per day. These numbers highlight and reinforce the importance of the prime brokerage business in the FX industry, as well as the role played by the smaller firms that have stepped up to the plate. These firms will continue to face the pressure of increased ticket and, most likely, client numbers, which means their investment programmes in technology and people must be maintained.

In our Prime Services Special Report we take a look at this most vital ecosystem at the heart of the FX market and seek to shed some light on the future of prime services.